The big myth about money and inflation
Money growth alone does not map into inflation. That is a myth and markets have learnt that. But joint monetary and fiscal expansion is a different matter, and markets may learn that next.
This is my first post for our new Money: Inside and Out venture. The idea is to have a lively debate. Hence, feedback is welcome.
I am into forecasting. It is challenging. But it also teaches you humility. Unexpected things may happen. Your forecast can be wrong, simply due to ‘bad luck’ (say if an unexpected pandemic hits). The other type of forecast error happens when your framework is wrong. And this is what is so interesting about inflation, and its link to monetary dynamics. Mostly an entire profession got it wrong. Not because of some unexpected event happened. But simply because the framework was wrong. There is no strong simply connection between monetary growth and inflation. That is the lesson from the last 10-20 years. We had plenty of monetary expansion, but no inflation to speak of in any major economy around the world. Markets have now firmly internalized that lesson.
The question is whether we are at a regime shift, in which monetary and fiscal policy are much more coordinated, and where the combination of fiscal and monetary (FisQEl policy) can matter for inflation. If that is the case, markets may again have something new to learn.
The myth about a simple link from money to inflation
It is worth giving a few examples of the ‘religion’ that stipulates that there is a simple link from monetary growth to inflation.
First, In the middle of the Global Financial Crisis there was an intense debate about the inflationary effects of the Fed’s ‘reckless’ monetary expansion, and many subscribed to the money-inflation religion.
Arthur Laffer’s is a good example. He was, and is, a well-known US economist, known for the so-called Laffer-curve (mentioned in many economic text books). Below is a screen shot of his Wall Street Journal op-ed from mid-2009. It stated confidently that inflation was about to explode as a function of excessive monetary easing (see link):
Second, I remember a CFA exam I went to, I believe in 2002. These exam questions are ‘secret’. Hence, you cannot google them. But there was a simple multiple choice question about what happens to inflation if monetary aggregates expand, as if there was a simple ‘mathematical’ answer to the question.
Third, you can try to google ‘money supply and inflation’. Almost all the first 10-20 hits will somehow state that there is a simple relationship between the two concepts. Once a myth is firmly engrained in thinking (and teaching), it can be very hard to get rid of it. Economics teaching has its share of ‘fake news’.
In reality, there no simple link between money and inflation
First, Japan is always an instructive case study, since the country has generally been at the forefront of ‘monetary experiments’ for the last twenty plus years.
The charts below shows a detailed view on the monetary expansion in Japan (from Exante Data’s liquidity monitor). Over the last decade or so, we observe dramatic monetary easing during ‘Abenomics’ starting in 2013, and further monetary easing in response to the COVID shock in 2020.
The main feature is that the BoJ has accumulated in the region 500 trillion JPY of government bonds, while bank reserves (the main component of M0) have sky-rocketed (a typical feature of ‘asset swap QE’). Specifically, monetary base has grown >400% over the period, and inflation remains stuck well below the BoJ’s 2% target. Monetary expansion has failed to map into inflation, even when the monetary expansion has been incredibly aggressive, as has been the explicit goal and reality under BoJ’s Kuroda/Abenomics.
Second, we can look at the evidence of a broader section of economies. The figure below looks at the average growth rate in the 8-years since the millennium to end-2007 (left panel) in contrast with the relation from end-2007 to Sept. 2020 (right panel).
Pre-GFC the relation between base money growth and inflation had still not entirely broken down. With the exception of China, where base money growth accelerated due the accumulation of foreign reserves by PBOC, base money growth was comparable to the growth of consumer prices over the period.
Turning to the period since end-2007 on the right side, again with the exception of China, all countries saw a sharp acceleration in base money growth. The simple average of base money growth (ex. China) increased to 15.6 percent (from 5.2 percent pre-GFC.) Recall, this growth rate has to be compounded over more than 12 years to get the base money stocks witnessed in Sept. this year. And despite this remarkable acceleration in base money growth, with the exceptions of China, Japan, and the UK, all countries saw inflation decelerate. Indeed, the cross-country relationship between base money expansion and inflation post-GFC indicates that the greater is base money growth the lower is the inflation outturn—turning the old monetary theories on their head!
Does money supply never matter?
While it is clear that there is no simple mechanical link between money supply and inflation, we would not push this conclusion so far as to say there is no linkage what-so-ever.
Monetary expansion can matter, and crucially, for inflation when combined with fiscal expansion.
It can be helpful to search for ‘stylized facts’ on this matter within emerging markets that have more ‘extreme histories’ in this area. Below is a summary of simple regression output from an IMF study on the subject (“The Modern Hyperinflation Cycle: Some New Empirical Regularities”, WP/18/266, by José Luis Saboin-García):
It shows that in these episodes (driven by a large sample of EM countries) base money growth does matter, as do fiscal variables. This is just one study. But it illustrates a key point, as Argentina's recent experience has also demonstrated.
The money printing (QE) of 2008-2019 was mostly an asset swap type monetary expansion. The central bank bought assets (bonds) and created bank reserves for the banking system. Simplistically, you could say there was very little direct effect on the real side of the economy, and on aggregate (consumer) price dynamics.
This is fundamentally different from a situation in which money printing is used to finance government spending, or tax cuts (not just asset purchases).
If money printing is associated with actual demand generation (via government spending, or transfers), then the link into inflation is likely to be much stronger.
This is a simple difference, between different types of monetary expansion. But somehow it has been missed by many, leading to ‘forecasting disasters’ by those who are ‘religious’ about the role of money in inflation dynamics.
What matters in a forward looking sense is whether we are truly in a new regime. A new regime in which aggressive money printing and fiscal expansion go hand in hand. I like to call it FisQEl policy. In this regime, money printing may indeed be associated with a real demand spike, and then it can very well be a part of a process that drives inflation higher.
If policy makers do venture down this new path, markets may again have something new to learn about the link between money and inflation.
“Outside money” growth can sit as dead reserves for a long time. Without a rise in final expenditure that is captured by gdp accounts no demand impetus is created. That’s the same as saying velocity has fallen. Demand growth is most often accompanied by a rise in credit or loans or “ inside money” in which case velocity remains stable. Merely stating velocity is falling doesn’t explain the fall
Thank you, Jens. Great blog.
Could the conclusion be simplified further to say: growth in M0(1) has a very low(zero) probability of causing inflation, but M4(or similar) growth has a decent probability of causing inflation, since M4 is linked much more to demand and credit creation than M0?